Falling inflation means these 2 retailers may be mispriced

In recent months, the rate of inflation has been on a downward trend. This is highly significant because it means that wage growth is now ahead of inflation for the first time in over a year. As a result, consumer disposable incomes are now growing in real terms, and this could help to lift consumer confidence after a period of ‘doom and gloom’.

Although the retail sector still faces an uncertain outlook, valuations across the industry may prove to be too low. In particular, the supermarket sector seems to offer value for money at the moment. This could make retail stocks such as Tesco (LON:TSCO) and Sainsbury’s (LON:SBRY) relatively appealing investments for the medium term.

Improving outlook

As mentioned, the fact that inflation is below wage growth could mean that consumer spending gains a boost. Just as during the financial crisis the retail sector experienced a period of discounting and margin pressure, in recent months the retail environment has been tough. Evidence of this can be seen in the profit warning released by Debenhams this week, as well as negative sales growth across the sector.


Now, though, sales growth could be positively catalysed by a real-terms rise in disposable incomes. Even before the recent fall in inflation, Tesco and Sainsbury’s had started to deliver sustained positive LFL sales growth. This was caused to at least some extent by their refreshed strategies.

For example, Tesco has concentrated on its core UK operations, with a focus on efficiency set to yield higher margins over the medium term. This is forecast to lead to EPS growth of 28% this year and 23% next year. Similarly, Sainsbury’s acquisition of Argos could push its rate of growth higher. It is expected to end three years of falling profitability to post mid-to-high single digit EPS growth over the next two years.

Competition

Clearly, the risks facing supermarkets from increasing competition have not rescinded following the recent fall in inflation. No-frills operators such as Aldi and Lidl continue to deliver on their ambitious expansion plans, and they could remain a disruptive force over the medium term.

However, if shoppers are not being squeezed by negative real wage growth, they may become less price conscious. This may mean that they prioritise convenience or customer service over cost, which could be good news for mid-tier operators such as Tesco and Sainsbury’s.

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Undoubtedly, it is too soon to say that the retail sector will now enjoy a period of sustained growth. Inflation could easily pick up to higher levels as Brexit talks progress, and this may put pressure on valuations across the sector.

However, the key point is that with Tesco and Sainsbury’s having PEG ratios of 0.7 and 1.5 respectively, they appear to be mispriced by the market. Therefore, there could be capital growth potential ahead, since their risk/reward ratios may prove to be more favourable than many investors have priced in. This means that they could perform relatively well, albeit in a potentially volatile fashion.